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Tax views article - Tax audit investigation and inquiry

In today’s world of government shortfalls and deficits, corporate taxpayers in many jurisdictions are seeing ever more requests for information from local tax authorities. Companies need to think differently to mitigate any potential information gathering issues and/or the potential difficulties which may arise during an audit with their local tax authority.

Highlights

Related content

In a recent webcast led by Sharon Katz-Pearlman, Global Head of Tax Dispute Resolution and Controversy Services (GTDR&C) and GTDR&C leaders from KPMG International’s network of firms in Australia, and the United Kingdom they shared their experiences and insights on creating audit-ready files, handling electronic data requests, preparing for interviews and onsite visits.

Electronic data requests, interview requests and preparing witnesses

Trends in electronic data requests

Around the world, tax authorities are initiating more electronic data requests as part of their domestic tax compliance programs, and they’re gaining access to more taxpayer information as a result. For example, the Australian Tax Office’s (ATO) Smarter Data program aims to update the ATO’s data and analytics capabilities to better target both domestic non-compliance. In China, the State Administration on Tax (SAT) has been driving taxpayers to conduct most of their transactions via the Internet, and the SAT’s deployment of data analytics for risk assessment and compliance verification is now routine.

Supplementing these domestic programs are international measures to promote cross-border transparency and the exchange of taxpayer information, which tax authorities are increasingly relying on to access taxpayer data. For example, the number of information exchange requests issued by the ATO rose from 291 in 2015 to 409 in 2016, and this number is expected to grow in 2017 and later years.

Meanwhile, tax authorities’ requests for information from taxpayers are becoming more rigorous and more frequent. Tax authorities are increasing their use of formal, statutory information-gathering powers to compel the production of electronic taxpayer data within tightening timeframes. The scope of their requests is widening beyond statutory accounts and local entities to cover foreign related parties, group structure information, pricing, financing arrangements, reorganizations and other material transactions, legal agreements, data integrity and decision-making processes, and more.

Dealing with these requests presents a host of challenges and can absorb considerable resources. For example:

Companies need to determine whether the tax authority has the power to compel the information in terms of both relevance and scope.

If the data is cloud-based, questions can arise over where the data resides and whether the entity being asked for the information has custody and control of it.

Because different tax authorities will review the same tax data through different lenses, it can be difficult to ensure consistency of tax data and related messaging across jurisdictions.

Bulk downloads of data need to be reviewed carefully to avoid the risk of transmitting information that constitutes a waiver of legal privilege in certain jurisdictions.

Companies need to carefully manage their response to these requests to ensure no “rogue” documents slip through the cracks that could disrupt claims of legal privilege, expose commercially sensitive information or present other problems. It’s also important to keep a clear record of the data provided and its source.

Advance preparation – in the form of real-time, audit-ready files, discussed later in this article – will put companies in the best position to deal with broad requests quickly and effectively.

What are tax authorities doing with all this data?

Through predictive analytics and other electronic techniques, tax authorities are mining taxpayer data to detect anomalies and mismatches between tax positions and accounting data. This data and other information is also being swept for patterns and trends to benchmark and risk assess taxpayers and industry segments, identify issues, select cases for audit, and inform tax policy evaluation and development.

Increasingly, tax authorities are sharing information and collaborating to improve their data gathering and analytic capabilities. The Organisation for Economic Co-operation and Development’s Forum on Tax Administration (FTA) is bringing together the world’s tax authorities to discuss data-related challenges and develop solutions. “Putting data to work” is the subheading of the FTA’s 2016 report Advanced Analytics for Better Tax Administration. This report sets out examples of how various tax authorities are using tax data today and makes recommendations on how this use could be improved to enhance tax administrations and produce better outcomes for taxpayers.

As with the ATO’s Smarter Data program, the tax authorities’ ultimate aim in using data management, risk assessment and technology is to make it easier to comply – and harder not to.

Preparing for interviews with tax authorities

In another emerging trend, tax authorities are supplementing their use of data and technology with in-person interviews with company executives and employees. The goal is to confirm the accuracy of tax filing positions and business purposes through the direct recollection of the people involved in making and implementing decisions having a tax impact. Properly managed, these interviews present a great opportunity to educate tax authorities about the business and the rationale behind tax positions taken.

However, the process is outside the company’s control, and there are significant risks if executives and employees do not fully understand the questions asked or the business reasons behind the company’s structures, arrangements and transactions. To lay the ground to a positive outcome, companies receiving interview requests from tax authorities and other regulators should consider:

who the tax authority wants to interview and whether another person might be better informed to deliver compelling answers

what the tax authority wants to know and why that information might be relevant

where, when and how the tax authority plans to conduct the interview, since interviewees’ stress levels will differ if the interview is conducted on the tax authorities’ premises, rather than onsite.

Simulating the interview in advance in an environment that mirrors expected interview conditions can go a long way toward helping interviewees understand how to field anticipated questions effectively and concisely. Mock interviews can give interviewees experience in asking tax authorities to clarify questions, including scope and intent, and help them confine their responses to the questions asked.

It’s also important to understand the tax authorities’ expectations and proposed next steps when the interview concludes. A written transcript or detailed notes should be prepared to document the interview and its anticipated outcomes.

Preparing for site visits from tax authorities, developments in joint audits

— Sharon Katz-Pearlman, Global Head of Tax Dispute Resolution and Controversy Services (GTDR&C) and National Principal-in-Charge of KPMG’s Tax Controversy Services practice, KPMG in the US.

Preparing for site visits – practical considerations

In addition to interviewing executives and employees, site visits to taxpayers’ premises are becoming common practice among tax authorities. By visiting specific business locations, tax authorities can see the facility firsthand, get a better understanding of the business and, in some cases, gain additional information by interviewing company personnel informally.

If a site interview is expected, companies should prepare in advance to make sure the information that will be provided is accurate and clear. Information provided in spur-of-the-moment interviews is generally not helpful for either the taxpayer or the tax authority, since inaccuracies can lead to problems down the road that can be difficult and costly to clarify.

Before any site visit, it’s important to set clear expectations among employees by explaining what is happening and why, even for those who will not be affected directly by the visit. It’s also important to ensure that the person conducting the tour is knowledgeable about the facility and what activities it does and does not do. Finally, it’s advisable to establish a separate, secure location for any impromptu discussions that may take place to build interviewees’ comfort, preserve confidentiality and avoid any inadvertent waiver of privilege.

Developments in joint audits

The importance of the above advice on handling information requests and preparing for interviews and site visits multiplies where more than one tax authority is involved. Joint audit approaches – in which two or more tax authorities examine the same taxpayer issues in concert – have been the subject of various pilot projects over the past few years.

After the release of a 2011 FTA report on how joint audits should be conducted, a limited OECD pilot project was initiated, followed by informal Internal Revenue Service pilots involving tax authorities in Canada, the United Kingdom and Australia. The European Union’s Joint Audit Initiative has introduced such programs in Europe, bringing aboard countries, such as France, that were previously reluctant to take part.

In a related development, the OECD and the United Nations are sponsoring the “Tax Inspectors Without Borders” program to help countries build their tax audit capacity. The program connects tax auditors from more developed countries with their counterparts in less developed countries to share best practices and train agents in tax audit techniques.

The latest development from the OECD is a pilot project for joint risk assessment audits. Under the International Compliance Assurance Program, (“ICAP”) multiple tax authorities work collaboratively to conduct risk assessments for international corporate groups. This approach allows tax authorities to leverage available information efficiently and produce consistent risk analyses. Taxpayers benefit from the ability to present their facts and positions to all participating tax authorities at the same time. At the conclusion of the risk assessment, the individual countries will decide whether or not they which to pursue a tax examination of the entity. Note that ICAP is a risk assessment and not a tax assessment process.

Companies that are approached by tax authorities to participate in a joint audit or risk assessment program should consider the potential benefits. Taxpayers can not only gain efficiencies by providing one response to the same queries from multiple tax authorities. They can also avoid the need to seek adjustments through mutual agreement procedures by gaining the agreement of tax authorities on tax positions as the joint audit progresses.

Creating audit-ready files and managing email requests

— Kevin Elliott, Director, Tax, KPMG in the UK

Implementation testing on the rise

It cannot be said often enough: proper documentation is crucial to the success of transactions that have tax consequences. Even the most rigorously supported tax position can be undermined if it is not well documented and properly implemented. In the experience of KPMG in the UK, the reason why most tax arrangements fail comes down to lapses in implementation and documentation, rather than any failings in the underlying tax analysis.

In fact, documentation is becoming more important than ever as tax authorities increasingly test the implementation of tax planning arrangements through their enforcement practices. Within the HM Revenue & Customs (HMRC) Litigation and Settlement Strategy officers are instructed to test implementation, for example, by ensuring transactions are effected as described and/or that a qualified advisor has reviewed and attested to the positive results of such a due diligence exercise. Implementation testing is usually undertaken before evaluation of the technical analysis that supports a transaction. If there are any flaws in the implementation this may mean the intended tax benefits are not achieved and HMRC does not then need to go to the trouble of more resource-intensive technical challenges to the tax analysis.

Along with testing of an arrangement’s initial implementation, HMRC is testing the ongoing operation of arrangements that produce annual tax benefits which may depend on actions or decisions made periodically. Such arrangements can include:

arrangements where HMRC suspect gaining a tax advantage may be a main purpose, such as ongoing debt financing arrangements

tax residency and permanent establishment issues, which are highly sensitive to actions and decisions made by individuals made over an arrangement’s life cycle

Diverted Profits Tax (DTP), where HMRC are routinely asking corporate groups to explain the theory of their business value chain and the basis on which profits are attributed among members of an international corporate group.

Where the DTP is concerned, HMRC has been seen to issue broad information requests. Although the initial consequences of failing to fulfill these requests are not severe, such failure starts the clock for the application of severe daily and even tax-related penalties for non-compliance.

Document now, save time and expense later

The best way to ensure your company is prepared for any broad information request from a tax authority is to fully document transactions, the commercial rationale and supporting analysis at the time the transaction is taken. This approach is much more efficient than documenting transactions when filing the related tax return or responding to a tax authority request. Memories can fade, and people often move on. Documentation prepared months or years after-the-fact is rarely as accurate and complete as documentation prepared in real time. Contemporaneous documentation is also much less expensive to prepare when transactions are in progress – up to about 10 times cheaper, in the experience of KPMG in the UK.

Key elements of audit-ready filesAn audit-ready file should start with an executive summary of the transaction and its tax consequences. This helps ensure readers grasp an understanding of the transactions before they get into the detail. The summary should explicitly describe the commercial rationale for the transaction, since these reasons may be less obvious to tax auditors than they are to people in the business.

The file should also include:

steps plan/chronology, including documentation proving those steps were properly executed

tax advice, which may or may not be shared in response to a tax authority request, but will help company personnel understand the transaction’s context if referred to in the future

legal advice, appropriately marked as ‘privileged’ where appropriate

informal documents and correspondence, such as notes of meetings and phone calls, and emails where the transactions commercial motive or purpose may be relevant.

The complete file should be reviewed to correct any errors and remove superfluous and duplicate information (including early drafts of documents).

Managing email requests

In the past, tax authorities tended to ask to review company emails in exceptional circumstances. Recently, these requests have become more routine. Tax authorities now tend to look to informal documentation, such as emails, to verify what is recorded in formal documentation (e.g. contracts, board resolutions) and to ensure transactions were executed as planned. Tax authorities have been known to use information in emails, such as those sent in advance of board meetings, as evidence to discredit a transactions stated purpose.

Everyone involved in tax-sensitive transactions – from directors and executives to finance, tax and business unit staff – should be educated about the risks emails pose. Emails should be treated the same as formal written correspondence, and non-tax specialists should refrain from making any tax-related comments that might be misconstrued. Only appropriate people should be involved in requesting and receiving legal advice in order to preserve legal privilege if available. Each email should clearly reference the project being discussed and only address one project; addressing multiple projects in the same email can lead to misunderstandings that may be difficult or costly to correct.

A good practice is to appoint one person to collate emails relevant to a transaction. This person can be charged with ensuring emails are retained to support the chronology and decisions made about the transaction, and with removing any material that is not relevant.

Managing tax authority requests for emails

Tax authorities in the UK and elsewhere will have powers to request information, including emails, but taxpayers can take steps to manage these requests, improving efficiency to the benefit of everyone involved.

When a request for emails is received, a first step is to verify that the request is reasonable and not unduly onerous, and that the tax authority is not requesting irrelevant information. Next, consider whether alternative evidence can provide the information sought more efficiently, for example, through discussions with or written statements from key people involved in the transaction. Also consider working with the tax authority proactively to define the scope of the request by recommending what emails should be provided as evidence. This can save a company and the tax authority from the time and expense of considering information that is not relevant to the issue at hand.

Email evidence that you do provide should be accompanied by a note confirming the extent of the email search, including which people’s folders were searched, search terms used and time periods reviewed. With this reassurance, the tax authority is less likely to come back with further requests.

In summary, preparing contemporaneous, audit-ready files should be common practice for all material and/or tax-sensitive transactions. Compared to the challenges of pulling together events and documents long after the transaction is complete, contemporaneous files are quicker, cheaper and easy to prepare – and much more likely to lead to a positive outcome.